1000x Systemic Leverage: $600 Trillion In Gross Derivatives "Backed" By $600 Billion In Collateral

Zero Hedge ^ | 12/24/2012 | Tyler Durden

[SeekAndFind]

There is much debate whether when it comes to the total notional size of outstanding derivatives, it is the gross notional that matters (roughly $600 trillion), or the amount which takes out biletaral netting and other offsetting positions (much lower). We explained previously how gross is irrelevant... until it is, i.e. until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis, i.e., the only time when gross derivative exposure becomes material (er, by definition). But a bigger question is what is the actual collateral backing this gargantuan market which is about 10 times greater than the world's combined GDP, because as the "derivative" name implies all this exposure is backed on some dedicated, real assets, somewhere. Luckily, the IMF recently released a discussion note titled "Shadow Banking: Economics and Policy" where quietly hidden in one of the appendices it answers precisely this critical question. The bottom line: $600 trillion in gross notional derivatives backed by a tiny $600 billion in real assets: a whopping 0.1% margin requirement! Surely nothing can possibly go wrong with this amount of unprecedented 1000x systemic leverage.

From the IMF:

Over-the-counter (OTC) derivatives markets straddle regulated systemically important financial institutions and the shadow banking world. Recent regulatory efforts focus on moving OTC derivatives contracts to central counterparties (CCPs). A CCP will be collecting collateral and netting bilateral positions. While CCPs do not have explicit taxpayer backing, they may be supported in times of stress. For example, the U.S. Dodd-Frank Act allows the Federal Reserve to lend to key financial market infrastructures during times of crises. Incentives to move OTC contracts could come from increasing bank capital charges on OTC positions that are not moved to CCP (BCBS, 2012).

 

The notional value of OTC contracts is about $600 trillion, but while much cited, that number overstates the still very sizable risks. A better estimate may be based on adding “in-the-money” (or gross positive value) and “out-of-the money” (or gross negative value) derivative positions (to obtain total exposures), further reduced by the “netting” of related positions. Once these are taken into account, the resulting exposures are currently about $3 trillion, down from $5 trillion (see table below; see also BIS, 2012, and Singh, 2010).

 

Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 - $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide.

And there it is: a world in which increasingly more sovereigns are insolvent, it is precisely these sovereigns (and other "AAA-rated" institutions) who are assumed to be so safe, they don't have to post any collateral to the virtually unlimited derivatives they are allowed to create out of thin air.

Is it any wonder why, then, in a world in which even the IMF says there is an increased demand for collateral, that banks are making a total mockery out of such preemptive attempts to safeguard the system, such as the Basel III proposal, whose deleveraging policies have been delayed from 2013 to 2014, and which will be delayed again and again, until, hopefully, everyone forgets all about them, and no financial crises ever again occur.

Because if and when they do, the entire world, which has now become one defacto AIG Financial Products subsidiary, and is spewing derivatives left and right, may have to scramble just a bit to procure some of this $599 trillion in actual collateral, once collateral chains start breaking, once "AAA-rated" counterparties (such as AIG had been days before its bailout) start falling, and once the question arises: just what is the true value of hard assets in a world in which the only value created by financial innovation is layering of derivatives upon derivatives, serving merely to prod banker bonuses to all time highs.

[HangnJudge]

Who gets the pot when this poker hand folds?

[andyk]

pfl - maybe someone will explain it in lay-terms by the time I get back...

[ClearCase_guy]

Picture yourself making $50,000 a year.
Now, picture yourself living in a $50M mansion.
Now, picture yourself trying to pay the mortgage on your $50M mansion, with your $50K salary.

Not completely equivalent, but the basic idea is that we cannot pay what we owe. Just cannot. The crash is inevitable, and will be severe. Trying to delay the crash makes it worse.

[donmeaker]

A derivative is a promise by the principal to pay the creditors at the back end, if a certain event occurs. To get the promise, a creditor pays in at the front end.

If a promise by the principal can’t be kept, it won’t be. Bankruptcy then voids the promises, and takes control of the remaining assets. The bankruptcy judge will allocate the assets among the various remaining creditors. Normally the party making the promise takes their profits out up front, and can thus walk away clean, and rich.

Derivatives are risky. One risk is the potential that some creditors, by contract, by law, or by corruption, stand in line before others. Assets paid out before bankruptcy are usually beyond control of the bankruptcy judge (exception is if corruption can be proved, then a ‘claw back’ can be attempted.

[21twelve]

So what. I took out the loan on the mansion using my $5,000 truck as collateral so I’m good. And the interest rate is really low now - so I would be a fool NOT to borrow as much money as possible.

Does anyone know if Bed & Bath rents linens?

[PGalt]

from zh poster Sudden Debt...

now your talking about a paper currency. we've passed that and are already fully into a digital currency where the flow can be much easier controlled.

This socialist-induced debt is the vehicle for TOTALITARIAN control. Think digital currency.

DEFUND socialist collectives, foreign and domestic. DEPOPULATE socialists from the body politic.

Socialism Is Legal Plunder - Bastiat

Socialists/Totalitarians are useless eaters living large off our time of life, all the while implementing further enslavement.

live - free - republic

[Mogger]

There's a good book that explains derivatives written in the 60s. I'll try to find it in my library.

Anyway, the Japanese invented the futures and options markets centuries ago to even out the cost of rice throughout the year.

It seems rice was so cheap at harvest, the farmers couldn't afford to grow it, and it was so expensive later in the year, the consumers couldn't afford to buy it.

The futures market was invented to solve this.

People with money to invest would pay farmers a sum of money on the promise to deliver rice at a certain price later in the year from harvest, more money than the farmers could sell for at harvest, but less than what the investors speculated the price would be later.

The speculators then sold the rice future to a merchant who would purchase the rice at the cost agreed upon with the farmer.

The farmer made more money, the consumer spent less than they would have later in the year.

All of the commodites we use, fuel oil, pork bellies, gasoline, wheat, corn, etc., are thus traded in this manner.

Futures are traded based on a delivery price for within a certain period of time, 6 months, a year, etc. Should the price not go up to at least the level agreed upon in the contract, plus a little, the contract become worthless at the end of the time, 6 months, etc.

Should the market price go up considerably, the holder of the contract can make proportionately more money.

There is a secondary market now, called the "options" market.

Options are traded on stocks, commodities futures, currency, etc.

Option trading is a way to make or lose a lot of money in a hurry.

An easier way to understand it is to think of real estate.

Suppose you know of a parcel of land for sale. You also know a freeway is going to be built there with a ramp right next to the property, perfect for a convenience store, etc.

The property owner doesn't know this.

You offer him a sum, say $1000 for the option to buy the property for $100,000 in the next year.

The development happens, the property becomes worth a million dollars. You exercise your option, buy and sell the land, making 900,000 less the thousand you paid for the option.

You could also sell your option, for perhaps $900,000 to the company that wants to build a store.

On the other hand, suppose the greenies stopped the freeway over some stupid mouse or newt.

You're only out your $1000.

In stocks or commodities this kind of option is called a "call".

You can also bet on the stock or commodity goung down. This is called a "put".

It doesn't take a great deal of money to control an option on a lot of stock or commodities.

The options, like futures are only for a certain amount of time, more often 6 months or a year.

There are longer options, called "leaps", good for 5 years.

Options are used by traders for mutual funds, banks, etc., both to make more money and to protect their investments.

Suppose you buy a thousand shares of a stock, with the idea it's going to appreciate.

At the same time you buy some puts on the stock, so you make money in case the value of the shares goes down.

If the stock goes really high or really low, you make money. If it wallows near what you paid for it, not only do you not make money, you lose what you spent on the puts to cover your shares.

Not many people understand options and futures. It isn't taught in universities to my knowledge. Successful traders are either self taught and/or go to classes run by other successful traders.

Idiots running banks and other institutions who have business degrees don't understand this.

They hire business or economic school grads thinking they do understand it.

These highly educated high self-esteem ignorant fools then trade with big money, and eventually blow it.

One think real option traders understand is you have to factor in losing.

You can turn a small amount of money into millions in a short time, and you can turn millions, or in the case of the bankers, trillions into nothing even faster.

It's a fun roller coaster ride, but you have to realize it's just educated gambling, a little better than going to Reno or Vegas, but not much.

[Secret Agent Man]

Derivatives seem awfully like fractional reserve lending, only on steroids. Both make stuff out of thin air, and expect to be paid back with real money.

[Big Horn]

What is the safest thing to invest in?

[ctdonath2]

Digital currency is debt. That’s the only way ownership of the bits can be validated.
This in contrast to paper currency, where the paper is imputed with actual value verified by simple possession.

[Gene Eric]

Lead.

[sarasmom]

As I understand it, there is no “pot”, just the final end point of the game plan.
The whole point of the game plan seems to be that moochers and leaches “win” by destroying the productive worlds current economic exchange system, and that the players will usher in a brand new system.
With the players themselves in positions of great power and wealth. They actually believe they have earned it.

What will actually happen is a world wide backlash and insane levels of both public and private violence by most of humanity.

Whether one calls it Armageddon or likens it to the book "Atlas Shrugged" or the movie "Planet of the Apes", the end result will be worldwide wars. It's not going to end well for anyone. And it's already started.

[sarasmom]

Guns and ammunition.

[usconservative]

Who gets the pot when this poker hand folds?

That would be the Bankers and Financiers. You and I, the poor taxpayer get screwed again without getting kissed first.

[samadams2000]

RGR/RYN/WY/BMY/CAG/ATK/DPM/COP/GNRC/SLW/SSRI/...my current portfolio.

[gotribe]

Bondholders as always. Unless obama steps in and rules their claims invalid.

[NewJerseyJoe]

P4L

[wiggen]

No. Pay what you owe in the case of a mortgage is a real debt. An amount is borrowed with the expectation of it being paid. That is not at all like these derivatives.
For example one of the largest, possibly the largest of all derivative markets is is bond insurance or CDS. One buys this insurance at a price derived from the credit worthiness of the issuer. You can insure a top rated bond for very little. A few dollars a year to cover every $1000 face amount (the actual quantities insured and not in single bond increments but this is easier to use to explain). Now the company selling (or buying) the insurance is accepting a few dollars to insure a much larger amount.The difference in what they take in and what is promised to pay in the event the company issuing the bond does not is all risk. It’s a potential obligation that becomes real in certain events. The company selling the insurance needs to put aside some reserves but nowhere near the amount potentially owed (like life insurance. That differential is what the article speaks to.

[outofsalt]

“Does anyone know if Bed & Bath rents linens?”
That’s in the, “Beyond” department;)